FOMC Preview

January 29, 2014

Chairman Bernanke’s eight-year tumultuous stewardship is down to its final detail and appears likely to go out like a lamb, not a lion, without so much as the fanfare of press conference. There is a new array of voting regional presidents on the Federal Open Market Committee, including the hawkish Dallas Fed President Fisher and the nouveau dovish Minneapolis Fed President Kocherlakota, so one are of interest will be to see who, if anybody, dissents from the majority action. I expect that action to be another $10 billion tapering of QE3 stimulus to $65 per month.

There is some risk that the committee instead defers from reducing quantitative stimulus again at this time, but that seems less than a 50:50 bet for the following four reasons.

At the handover of chairmanship, it’s better not to spring a surprise on the market.

Expectations of above-potential U.S. GDP growth in 2014 remain widespread. Data at worst have been mixed and clearly distorted by the winter of the century.

Market vital signs, shown in the table below, have not changed drastically. Since the prior meeting on December 18 when tapering began, the dollar has risen 0.3% against the euro and fallen 1.4% versus the yen. The 10-year Treasury yield is down 18 basis points. The DJIA, which was way overdue for a downward correction, has dropped 2.1% on net. Gold has firmed 2.3%, while West Texas Intermediate crude oil has slipped by 1.2%. None of these changes is remarkable or grounds to give pause.

Rather than prolonging the controversial QE3 program, which even supporters think is approaching diminishing returns on any cost/benefit scale, the better way to proceed with pro-growth and anti-deflation support is too rejigger forward guidance in such a way as to persuade doubters that the Fed Funds rate isn’t going higher before 2015, if then.

The big problem with tapering involves the collateral damage such is inflicting upon emerging markets and the risk of feedback loops from that development that could hurt the U.S. economy. In the event that further tapering is delayed or reduced in size to an incremental movement of $5 billion, I believe this factor will be the reason although Fed officials will be reluctant to say as much. There is a long tradition at the Fed of intentionally downplaying foreign economic trends or the dollar as reasons for changing domestic monetary policy.

The last area of interest in today’s FOMC meeting concerns the characterization of U.S. growth and price conditions and prospects. The current view is a moderately paced continuing recovery with some labor market improvement, sub-trend inflation, still-stable longer-term inflation expectations, and an in-house view that inflation will move tack toward its 2-2.5% objective over the medium term, which is being monitored very closely to ensure that the forecast is not overly optimistic.

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